Bad terms are like bad dinner guests, avoid them
By Justin Hall February 12, 2016
- Many of these terms are simply too difficult to understand
- Founders need to understand exactly what they’re getting into
VENTURE capital terms can be difficult to understand.
Bad dinner parties, however, are universal.
Working in the industry, I receive many questions that, when answered, often produce a blank stare, polite nod, and an quiet ‘note-to-self’ to Google a decipherable answer at more opportune time.
Without a doubt, the most common question concerns those terms that should be avoided at all costs, the ones that can easily make or break a new startup or founding team.
The problem is, many of these terms are simply too difficult to understand.
So I’ve taken to using dinner parties as a metaphor to explain some of the more detrimental terms most entrepreneurs should avoid. Anyone who’s responsible for preparing a meal for a dozen people, while juggling RSVPs, food allergies, and ballooning food budgets will understand.
Greater than 2x liquidation preferences
Suppose you invite some guests who offer to help pay for the ingredients, but expect the value of their dinner to be more than double what they contributed? Or even more?
If it isn’t, they’re perfectly willing to take what they’re entitled to and skip out on the dinner.
Translation: Liquidation preferences represent an additional hedge against risk for investors. In the event of an exit, investors with preference shares can convert those shares to common stock and share the financial spoils equally with everyone else, or if they judge the return to be less than what they put in, they can simply ask for their money back.
Liquidation multiples raise that threshold: Instead of being entitled to at least 1x their investment, investors are now entitled to that multiple. 1 to 2x is relatively common, but anything above that is unfriendly and irrational.
You know what, that one guest taking his share and skipping out effectively took away from other guests’ portions. Looks like dinner might not be as valuable as people expected.
Another guest opts to take his share and run, and then another, and another … at the end of the night, there might not be any dinner left!
Translation: Not so much a term as a condition of multiple investor agreement, liquidation overhang is the culmination of numerous liquidation preferences greater than 1x.
If one investor exercises his liquidation preference, that could meaningfully affect the proceeds of an exit. If it does, it might make more financial sense for other investors to exercise their own liquidation preferences.
This can continue in perpetuity until, when the dust has settled, all the proceeds have returned to investors, leaving nothing to the founders or common shareholders.
Too much dilution
Even the dinner hosts should expect to eat some of the food they’ve prepared. But with every guest chipping in money for food, by the time dinner is served, the hosts may only be entitled to the smallest scraps.
Translation: Avoid getting too diluted in the early rounds. Anything more than 30% for the first cheque is treacherous; above 40% and it’s positively predatory, as you’ll probably be a minority shareholder by the time the second cheque comes in.
Remember, the first round of funding will often be following by two or three, or even more. Will you still be as devoted to the success of your startup when you’re one shareholder of many?
Reverse vesting without good leaver clauses
“You’re leaving already? Dinner isn’t ready yet! Fine, leave! But you don’t get anything!”
Translation: Reverse vesting is fair and commonplace. When investors put money in, they want assurances that the founders are in it for the long haul.
Reverse vesting essentially means that, while founders may be entitled to some percentage of the company, they will receive those shares on a vesting schedule, usually over four years with a one-year cliff.
In the instances when founders must leave and if they fulfil the conditions of a ‘good leaver,’ they are entitled to the shares vested to them.
If there are no 'good leaver' clauses, however, the company or investors can purchase those vested shares at nominal value, which are usually cents on the dollar if they are common shares.
Reverse vesting without good leaver clauses actually creates an incentive to fire the founding team.
One guest takes a bite, complains about the quality of the food, and demands that he is entitled to more food without paying extra.
You’re not quite sure why that makes sense, but before you can argue, he’s piling more food onto his plate.
Translation: In the event of a down-round – when a funding round presents a share price lower than the preceding one – full-ratchet dilution retroactively rewards investors by effectively applying their previous investment against the new, lower price.
Anti-dilution protection is common for investors, but in the event of a down-round, it’s much friendlier to use weighted average dilution, which essentially reprices shares at the average of the old price and the new, lower price.
Unfair or impractical terms of control
“Don’t use that. I prefer cinnamon. Wait, no peppers; I have a sensitive stomach. Use skim milk, please, not whole-milk … ugh. This looks terrible, I’m inviting my friend to help you cook.”
Translation: Unless investors are putting in a significant chunk of funding, they aren’t entitled to a board seat. This goes especially if they are simply putting in money, and can’t provide any substantive credibility or value to the company.
If there is a board, founders should always push hard to have at least a seat, and if investors ask for otherwise, that can be considered a deal-breaker.
By the same token, reserved matters – the issues that require either approval from the board or a majority of shareholders – are commonplace, but should never become so granular that you must require board or shareholder approval for day-to-day tasks, hires, or spending.
The onus is on you
Like dinner parties, term sheets and fundraising can be extraordinarily complex and stressful. At the end of the day, founders are responsible for explicitly understanding exactly what they’re getting themselves into.
Once you take that investment, you’re in it for the long-haul. So the best thing you can do is ensure that the first money in won’t cause any needless harm down the line.
As with food, when it comes to fund-raising, don’t bite off more than you can chew.
Justin Hall is a principal at Golden Gate Ventures, an early-stage fund based in Singapore. You can reach him via Twitter at @JVinnyHall. This article first appeared on his blog and is reprinted here with his kind permission.
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